Page 47
Consumer Price Index (CPI)
A comprehensive measure used for estimation of price changes in a basket of goods and
services representative of consumption expenditure in an economy is called consumer price
index
The calculation involved in the estimation of CPI is quite rigorous. Various categories and
sub-categories have been made for classifying consumption items and on the basis of
consumer categories like urban or rural.
Based on these indices and sub-indices obtained, the final overall index of price is calculated
mostly by national statistical agencies.
It is one of the most important statistics for an economy and is generally based on the
weighted average of the prices of commodities. It gives an idea of the cost of living.
Inflation is measured using CPI. The percentage change in this index over a period of time
gives the amount of inflation over that specific period, i.e. the increase in prices of a
representative basket of goods consumed.
Explainer Video – Click Here
Wholesale Price Index (WPI)
Wholesale Price Index (WPI) represents the price of goods at a wholesale stage i.e. goods
that are sold in bulk and traded between organizations instead of consumers. WPI is used as
a measure of inflation in some economies.
WPI is used as an important measure of inflation in India. Fiscal and monetary policy
changes are greatly influenced by changes in WPI. In the United States, Producer Price Index
(PPI) is used to measure inflation.
WPI is an easy and convenient method to calculate inflation. Inflation rate is the difference
between WPI calculated at the beginning and the end of a year. The percentage increase in
WPI over a year gives the rate of inflation for that year.
Fiscal Deficit
The difference between total revenue and total expenditure of the government is termed as
fiscal deficit. It is an indication of the total borrowings needed by the government. While
calculating the total revenue, borrowings are not included.
Page 48
The gross fiscal deficit (GFD) is the excess of total expenditure including loans net of
recovery over revenue receipts (including external grants) and non-debt capital receipts.
The net fiscal deficit is the gross fiscal deficit less net lending of the Central government.
Generally fiscal deficit takes place either due to revenue deficit or a major hike in capital
expenditure. Capital expenditure is incurred to create long-term assets such as factories,
buildings and other development.
A deficit is usually financed through borrowing from either the central bank of the country
or raising money from capital markets by issuing different instruments like treasury bills and
bonds.
Explainer Video – Click Here
Inflation
Inflation is the percentage change in the value of the Wholesale Price Index (WPI) on a yearon
year basis. It effectively measures the change in the prices of a basket of goods and
services in a year. In India, inflation is calculated by taking the WPI as base.
Formula for calculating Inflation =
(WPI in month of current year-WPI in same month of previous year)
-------------------------------------------------------------------------------------- X 100
WPI in same month of previous year
Inflation occurs due to an imbalance between demand and supply of money, changes in
production and distribution cost or increase in taxes on products. When economy
experiences inflation, i.e. when the price level of goods and services rises, the value of
currency reduces. This means now each unit of currency buys fewer goods and services.
It has its worst impact on consumers. High prices of day-to-day goods make it difficult for
consumers to afford even the basic commodities in life. This leaves them with no choice but
to ask for higher incomes. Hence the government tries to keep inflation under control.
Contrary to its negative effects, a moderate level of inflation characterizes a good economy.
An inflation rate of 2 or 3% is beneficial for an economy as it encourages people to buy
more and borrow more, because during times of lower inflation, the level of interest rate
Page 49
also remains low. Hence the government as well as the central bank always strive to achieve
a limited level of inflation.
Types of Inflation
Creeping Inflation:
When prices rise at very slow rate, i.e. creeper’s speed, it is called ‘creeping inflation.
Generally 3% annual rise in prices is considered as ‘creeping inflation’.
Walking or Trotting Inflation:
When inflation is in between 3% to 7%, it’s regarded as ‘walking or trotting inflation’. Some
economists have extended the boundary of this type of inflation up to 10% per annum. This
type of inflation is considered as a warning signal for the government to take some
measures to control the situation.
Running Inflation:
This type of inflation comes into action when there’s a rapid rise in prices and the range of
this type lies in between 10% to 20% per annum. This type of inflation is controllable only by
strong monetary and fiscal measures, lest it will be turned into ‘hyper-inflation’.
Hyper Inflation or Galloping Inflation:
The rise of prices from 20% to 100 % per annum is regarded as ‘hyper-inflation’ or ‘galloping
inflation’. This case of inflation is uncontrollable.
Demand Pull Inflation:
This type of inflation is due to an excess demand. In this case supply remains constant
(couldn’t be upgraded as per demand). So consequently, the prices go up.
Cost Push Inflation:
When there’s increase in money-wages at speedier rate than that of the rise in the
productivity of labour, it results as increased cost of production which furthers the increase
in prices. This type of inflation is regarded as cost push inflation.
Mixed Inflation:
Majority of the economists hold that, inflation is neither completely ‘demand pull’ nor
completely ‘cost push’, the actual inflationary process contains the elements of both. Excess
demand and increase in money wages operate at the same time, but it’s not necessary that
they start at the same time.
Page 50
Markup inflation:
Garner Akley put forward the theory of ‘mark-up inflation’. In simple words it is an advanced
explaination of ‘Mixed inflation’. According to Akley First comes demand pull inflation, and it
is led by cost push inflation. Markup inflation comes to happen when excess demand
increases the prices, which stimulates the production. The increasing production creates
excessive demand for the factors of production, and the excessive demand for the factors of
production further raises the prices.
Monetary Policy
What a CENTRAL BANK does to control the MONEY SUPPLY, and thereby manage DEMAND.
Monetary policy involves OPEN-MARKET OPERATIONS, RESERVE REQUIREMENTS and
changing the short-term rate of interest. It is one of the two main tools of
MACROECONOMIC POLICY, the side-kick of FISCAL POLICY, and is easier said than done well.
The RBI uses the interest rate, Open Market Operations (OMO), changes in banks' CRR and
primary placements of government debt to control the money supply. OMO, primary
placements and changes in the CRR are the most popular instruments used.
Under the OMO, the RBI buys or sells government bonds in the secondary market.
By absorbing bonds, it drives up bond yields and injects money into the market.
When it sells bonds, it does so to suck money out of the system.
The changes in CRR affect the amount of free cash that banks can use to lend -
reducing the amount of money for lending cuts into overall liquidity, driving interest
rates up, lowering inflation and sucking money out of markets.
Primary deals in government bonds are a method to intervene directly in markets,
followed by the RBI. By directly buying new bonds from the government at lower
than market rates, the RBI tries to limit the rise in interest rates that higher
government borrowings would lead to
Philips Curve
An economic concept developed by A. W. Phillips stating that inflation and unemployment
have a stable and inverse relationship. The theory states that with economic growth comes
inflation, which in turn should lead to more jobs and less unemployment. The concept has
been proven empirically and some government policies are directly influenced by it. Some
level of inflation could be considered desirable in order to minimize unemployment.
Page 51
Laffer Curve
Invented by Arthur Laffer, this curve shows the relationship between tax rates and tax
revenue collected by governments. The chart below shows the Laffer Curve:
The curve suggests that, as taxes increase from low levels, tax revenue collected by the
government also increases.
It also shows that tax rates increasing after a certain point (T*) would cause people not to
work as hard or not at all, thereby reducing tax revenue.
Eventually, if tax rates reached 100% (the far right of the curve), then all people would
choose not to work because everything they earned would go to the government.
Governments would like to be at point T*, because it is the point at which the government
collects maximum amount of tax revenue while people continue to work hard.
Page 52
Engel’s Curve
Engel's law is an observation in economics stating that, with a given set of tastes and
preferences, as income rises, the proportion of income spent on food falls, even if actual
expenditure on food rises. In other words, the income elasticity of demand of food is less
than 1. The law was named after the statistician Ernst Engel.
An Engel curve is the relationship between the amount of a product that people are willing
to buy and their income. An Engel curve is shown below.
Lorenz Curve and Gini Coefficient
A Lorenz curve shows the degree of inequality that exists in the distributions of two
variables, and is often used to illustrate the extent that income or wealth are distributed
unequally in a particular society.
The Gini coefficient is the area between the line of perfect equality and the observed Lorenz
curve, as a percentage of the area between the line of perfect equality and the line of
perfect inequality. A Gini coefficient is a summary numerical measure of how unequally one
variable is related to another. The Gini coefficient is a number between 0 and 1, where
perfect equality has a Gini coefficient of zero, and absolute inequality yields a Gini
coefficient of 1.
Page 53
Misery Index
Created by: Economist Arthur Okun
It is the sum of a country’s INFLATION and UNEMPLOYMENT rates. The higher the score, the
greater is the economic misery.
Trade Barriers
A trade barrier is a general term that describes any government policy or regulation that
restricts international trade. The barriers can take many forms, including:
Import duties
Import licenses
Export licenses
Import quotas
Tariffs
Subsidies
Non-tariff barriers to trade
Voluntary Export Restraints
Local Content Requirements
Non-Tariff Trade Barriers
Non-tariff barriers to trade are trade barriers that restrict imports but are not in the usual
form of a tariff. Some of the common examples are anti-dumping measures and
countervailing duties, which, although they are called "non-tariff" barriers, have the effect
of tariffs but are only imposed under certain conditions. Their use has risen sharply after the
WTO rules led to a very significant reduction in tariff use.
Page 54
Now what is Counter Vailing duty
Countervailing duties (CVDs) are a means to restrict international trade. They are imposed
when a foreign country subsidizes its exports, hurting domestic producers.
Deflation
When the overall price level decreases so that inflation rate becomes negative, it is called
deflation. It is the opposite of the often-encountered inflation.
A reduction in money supply or credit availability is the reason for deflation in most cases.
Reduced investment spending by government or individuals may also lead to this situation.
Deflation leads to a problem of increased unemployment due to slack in demand.
Central banks aim to keep the overall price level stable by avoiding situations of severe
deflation/inflation. They may infuse a higher money supply into the economy to counterbalance
the deflationary impact. In most cases, a depression occurs when the supply of
goods is more than that of money.
Deflation is different from disinflation as the latter implies decrease in the level of inflation
whereas on the other hand deflation implies negative inflation.
Foreign Exchange Reserves
Forex reserves are foreign currency assets held by the central banks of countries.
These assets include foreign marketable securities, monetary gold, special drawing rights
(SDRs) and reserve position in the IMF. The main purpose of holding foreign exchange
reserves is to make international payments and hedge against exchange rate risks.
Special Drawing Rights
This is a kind of reserve of foreign exchange assets comprising leading currencies globally
and created by the International Monetary Fund in the year 1969
Before its creation, the international community had to face several restrictions in
increasing world trade and the level of financial development as gold and US dollars, which
were the only means of trade, were in limited quantities. In order to address the issue, SDR
was created by the IMF.
SDR is often regarded as a 'basket of national currencies' comprising four major currencies
of the world - US dollar, Euro, British Pound and Yen (Japan). The basket will be expanded to
include the Chinese renminbi (RMB) as the fifth currency, effective October 1, 2016. The
composition of this basket of currencies is reviewed every five years wherein the weightage
of currencies sometimes get altered
Consumer Price Index (CPI)
A comprehensive measure used for estimation of price changes in a basket of goods and
services representative of consumption expenditure in an economy is called consumer price
index
The calculation involved in the estimation of CPI is quite rigorous. Various categories and
sub-categories have been made for classifying consumption items and on the basis of
consumer categories like urban or rural.
Based on these indices and sub-indices obtained, the final overall index of price is calculated
mostly by national statistical agencies.
It is one of the most important statistics for an economy and is generally based on the
weighted average of the prices of commodities. It gives an idea of the cost of living.
Inflation is measured using CPI. The percentage change in this index over a period of time
gives the amount of inflation over that specific period, i.e. the increase in prices of a
representative basket of goods consumed.
Explainer Video – Click Here
Wholesale Price Index (WPI)
Wholesale Price Index (WPI) represents the price of goods at a wholesale stage i.e. goods
that are sold in bulk and traded between organizations instead of consumers. WPI is used as
a measure of inflation in some economies.
WPI is used as an important measure of inflation in India. Fiscal and monetary policy
changes are greatly influenced by changes in WPI. In the United States, Producer Price Index
(PPI) is used to measure inflation.
WPI is an easy and convenient method to calculate inflation. Inflation rate is the difference
between WPI calculated at the beginning and the end of a year. The percentage increase in
WPI over a year gives the rate of inflation for that year.
Fiscal Deficit
The difference between total revenue and total expenditure of the government is termed as
fiscal deficit. It is an indication of the total borrowings needed by the government. While
calculating the total revenue, borrowings are not included.
Page 48
The gross fiscal deficit (GFD) is the excess of total expenditure including loans net of
recovery over revenue receipts (including external grants) and non-debt capital receipts.
The net fiscal deficit is the gross fiscal deficit less net lending of the Central government.
Generally fiscal deficit takes place either due to revenue deficit or a major hike in capital
expenditure. Capital expenditure is incurred to create long-term assets such as factories,
buildings and other development.
A deficit is usually financed through borrowing from either the central bank of the country
or raising money from capital markets by issuing different instruments like treasury bills and
bonds.
Explainer Video – Click Here
Inflation
Inflation is the percentage change in the value of the Wholesale Price Index (WPI) on a yearon
year basis. It effectively measures the change in the prices of a basket of goods and
services in a year. In India, inflation is calculated by taking the WPI as base.
Formula for calculating Inflation =
(WPI in month of current year-WPI in same month of previous year)
-------------------------------------------------------------------------------------- X 100
WPI in same month of previous year
Inflation occurs due to an imbalance between demand and supply of money, changes in
production and distribution cost or increase in taxes on products. When economy
experiences inflation, i.e. when the price level of goods and services rises, the value of
currency reduces. This means now each unit of currency buys fewer goods and services.
It has its worst impact on consumers. High prices of day-to-day goods make it difficult for
consumers to afford even the basic commodities in life. This leaves them with no choice but
to ask for higher incomes. Hence the government tries to keep inflation under control.
Contrary to its negative effects, a moderate level of inflation characterizes a good economy.
An inflation rate of 2 or 3% is beneficial for an economy as it encourages people to buy
more and borrow more, because during times of lower inflation, the level of interest rate
Page 49
also remains low. Hence the government as well as the central bank always strive to achieve
a limited level of inflation.
Types of Inflation
Creeping Inflation:
When prices rise at very slow rate, i.e. creeper’s speed, it is called ‘creeping inflation.
Generally 3% annual rise in prices is considered as ‘creeping inflation’.
Walking or Trotting Inflation:
When inflation is in between 3% to 7%, it’s regarded as ‘walking or trotting inflation’. Some
economists have extended the boundary of this type of inflation up to 10% per annum. This
type of inflation is considered as a warning signal for the government to take some
measures to control the situation.
Running Inflation:
This type of inflation comes into action when there’s a rapid rise in prices and the range of
this type lies in between 10% to 20% per annum. This type of inflation is controllable only by
strong monetary and fiscal measures, lest it will be turned into ‘hyper-inflation’.
Hyper Inflation or Galloping Inflation:
The rise of prices from 20% to 100 % per annum is regarded as ‘hyper-inflation’ or ‘galloping
inflation’. This case of inflation is uncontrollable.
Demand Pull Inflation:
This type of inflation is due to an excess demand. In this case supply remains constant
(couldn’t be upgraded as per demand). So consequently, the prices go up.
Cost Push Inflation:
When there’s increase in money-wages at speedier rate than that of the rise in the
productivity of labour, it results as increased cost of production which furthers the increase
in prices. This type of inflation is regarded as cost push inflation.
Mixed Inflation:
Majority of the economists hold that, inflation is neither completely ‘demand pull’ nor
completely ‘cost push’, the actual inflationary process contains the elements of both. Excess
demand and increase in money wages operate at the same time, but it’s not necessary that
they start at the same time.
Page 50
Markup inflation:
Garner Akley put forward the theory of ‘mark-up inflation’. In simple words it is an advanced
explaination of ‘Mixed inflation’. According to Akley First comes demand pull inflation, and it
is led by cost push inflation. Markup inflation comes to happen when excess demand
increases the prices, which stimulates the production. The increasing production creates
excessive demand for the factors of production, and the excessive demand for the factors of
production further raises the prices.
Monetary Policy
What a CENTRAL BANK does to control the MONEY SUPPLY, and thereby manage DEMAND.
Monetary policy involves OPEN-MARKET OPERATIONS, RESERVE REQUIREMENTS and
changing the short-term rate of interest. It is one of the two main tools of
MACROECONOMIC POLICY, the side-kick of FISCAL POLICY, and is easier said than done well.
The RBI uses the interest rate, Open Market Operations (OMO), changes in banks' CRR and
primary placements of government debt to control the money supply. OMO, primary
placements and changes in the CRR are the most popular instruments used.
Under the OMO, the RBI buys or sells government bonds in the secondary market.
By absorbing bonds, it drives up bond yields and injects money into the market.
When it sells bonds, it does so to suck money out of the system.
The changes in CRR affect the amount of free cash that banks can use to lend -
reducing the amount of money for lending cuts into overall liquidity, driving interest
rates up, lowering inflation and sucking money out of markets.
Primary deals in government bonds are a method to intervene directly in markets,
followed by the RBI. By directly buying new bonds from the government at lower
than market rates, the RBI tries to limit the rise in interest rates that higher
government borrowings would lead to
Philips Curve
An economic concept developed by A. W. Phillips stating that inflation and unemployment
have a stable and inverse relationship. The theory states that with economic growth comes
inflation, which in turn should lead to more jobs and less unemployment. The concept has
been proven empirically and some government policies are directly influenced by it. Some
level of inflation could be considered desirable in order to minimize unemployment.
Page 51
Laffer Curve
Invented by Arthur Laffer, this curve shows the relationship between tax rates and tax
revenue collected by governments. The chart below shows the Laffer Curve:
The curve suggests that, as taxes increase from low levels, tax revenue collected by the
government also increases.
It also shows that tax rates increasing after a certain point (T*) would cause people not to
work as hard or not at all, thereby reducing tax revenue.
Eventually, if tax rates reached 100% (the far right of the curve), then all people would
choose not to work because everything they earned would go to the government.
Governments would like to be at point T*, because it is the point at which the government
collects maximum amount of tax revenue while people continue to work hard.
Page 52
Engel’s Curve
Engel's law is an observation in economics stating that, with a given set of tastes and
preferences, as income rises, the proportion of income spent on food falls, even if actual
expenditure on food rises. In other words, the income elasticity of demand of food is less
than 1. The law was named after the statistician Ernst Engel.
An Engel curve is the relationship between the amount of a product that people are willing
to buy and their income. An Engel curve is shown below.
Lorenz Curve and Gini Coefficient
A Lorenz curve shows the degree of inequality that exists in the distributions of two
variables, and is often used to illustrate the extent that income or wealth are distributed
unequally in a particular society.
The Gini coefficient is the area between the line of perfect equality and the observed Lorenz
curve, as a percentage of the area between the line of perfect equality and the line of
perfect inequality. A Gini coefficient is a summary numerical measure of how unequally one
variable is related to another. The Gini coefficient is a number between 0 and 1, where
perfect equality has a Gini coefficient of zero, and absolute inequality yields a Gini
coefficient of 1.
Page 53
Misery Index
Created by: Economist Arthur Okun
It is the sum of a country’s INFLATION and UNEMPLOYMENT rates. The higher the score, the
greater is the economic misery.
Trade Barriers
A trade barrier is a general term that describes any government policy or regulation that
restricts international trade. The barriers can take many forms, including:
Import duties
Import licenses
Export licenses
Import quotas
Tariffs
Subsidies
Non-tariff barriers to trade
Voluntary Export Restraints
Local Content Requirements
Non-Tariff Trade Barriers
Non-tariff barriers to trade are trade barriers that restrict imports but are not in the usual
form of a tariff. Some of the common examples are anti-dumping measures and
countervailing duties, which, although they are called "non-tariff" barriers, have the effect
of tariffs but are only imposed under certain conditions. Their use has risen sharply after the
WTO rules led to a very significant reduction in tariff use.
Page 54
Now what is Counter Vailing duty
Countervailing duties (CVDs) are a means to restrict international trade. They are imposed
when a foreign country subsidizes its exports, hurting domestic producers.
Deflation
When the overall price level decreases so that inflation rate becomes negative, it is called
deflation. It is the opposite of the often-encountered inflation.
A reduction in money supply or credit availability is the reason for deflation in most cases.
Reduced investment spending by government or individuals may also lead to this situation.
Deflation leads to a problem of increased unemployment due to slack in demand.
Central banks aim to keep the overall price level stable by avoiding situations of severe
deflation/inflation. They may infuse a higher money supply into the economy to counterbalance
the deflationary impact. In most cases, a depression occurs when the supply of
goods is more than that of money.
Deflation is different from disinflation as the latter implies decrease in the level of inflation
whereas on the other hand deflation implies negative inflation.
Foreign Exchange Reserves
Forex reserves are foreign currency assets held by the central banks of countries.
These assets include foreign marketable securities, monetary gold, special drawing rights
(SDRs) and reserve position in the IMF. The main purpose of holding foreign exchange
reserves is to make international payments and hedge against exchange rate risks.
Special Drawing Rights
This is a kind of reserve of foreign exchange assets comprising leading currencies globally
and created by the International Monetary Fund in the year 1969
Before its creation, the international community had to face several restrictions in
increasing world trade and the level of financial development as gold and US dollars, which
were the only means of trade, were in limited quantities. In order to address the issue, SDR
was created by the IMF.
SDR is often regarded as a 'basket of national currencies' comprising four major currencies
of the world - US dollar, Euro, British Pound and Yen (Japan). The basket will be expanded to
include the Chinese renminbi (RMB) as the fifth currency, effective October 1, 2016. The
composition of this basket of currencies is reviewed every five years wherein the weightage
of currencies sometimes get altered
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