Economics Handout 1

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IASBABA’S
PRELIMS EXCLUSIVE
PROGRAM (PEP) 2022
ECONOMY HANDOUTS
WWW.IASBABA.COM, PEP@IASBABA.COM
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PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY
TOPICS: Economics basics- Macro & Micro, National income, Sectors - Primary, Secondary,
Tertiary, GDP & alternatives, Economic Systems -Capitalist, Socialist, Mixed Economy;
Inflation, Types of Inflation, Effects of Inflation, Steps to check inflation, Indices to
measure Inflation, Related Terms
BRANCHES OF ECONOMICS
SECTORS IN ECONOMY
Primary sector Which makes direct use of natural resources - Agriculture and allied
activities, Forestry, Fishing etc
Secondary or Which transform inputs into output. This sector includes the following
Industry Sector production activities - Mining and Quarrying (in India it is considered as
secondary sector), Manufacturing, Construction, Electricity Gas and
water supply & other utility services
Tertiary or Service Services providers - Trade, repair, hotels, transport, communication
Sector and services related to broadcasting, Financial, real estate &
professional services, Public Administration, defence and other services
Quaternary sector It includes all industries that are concerned with the creation and
distribution of knowledge. Ex: Research & development, Education etc.
Also known as “Knowledge Sector”. Defines quality of human resources
Quinary sector Highest levels of decision making in an economy.
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ECONOMIC SYSTEMS
Basis Capitalist Economy Socialist Economy Mixed Economy
Ownership of Private ownership Public ownership Both public and private
Property ownership
Price Prices are Prices are Prices are determined by central
Determination determined by the determined by the planning authority and demand
market forces of central planning and supply.
demand and supply authority.
Motive of Profit motive Social welfare The profit motive in the private
Production sector and welfare motive in the
public sector.
Role of No role Complete role Full role in the public sector and
Government limited role in the private sector
Competition Exists No competition Exist only in the private sector
Distribution of Very Unequal Quite Equal Considerable inequalities exist.
income
Open- economy Closed- economy

Which has economic relations with the rest Which has no economic relations with the rest
of the world. Most countries of the world of the world. Example - North Korea
are open economy.
In an open economy, exports constitute an In closed economy Saving and investment, Gross
additional source of demand for domestic Domestic Product (GDP) and Gross National
goods and services. Product (GNP) are equal but in an open
economy, they can differ.
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NATIONAL INCOME
National income is the total value a country’s final output of all new goods and services
produced in one year. Typically, goods are produced in a number of ‘stages’, where raw
materials are converted by firms at one stage, then sold to firms at the next stage. Value is
added at each, intermediate, stage, and, at the final stage, the product is given a retail
selling price. The retail price reflects the value added in terms of all the resources used in all
the previous stages of production.
Gross Market value of all final goods and services produced within the domestic
Domestic economy during a year.
Product or GDP at market price = Gross Value Added (GVA) at basic price + Indirect tax-
(GDP) Subsidies
For India, this calendar year is from 1st April to 31st March
Gross means total; domestic’ means all economic activities done whithin the
boundary of a nation/ country and by its own capital; ‘product’ is used to
define ‘goods and services’ together; and ‘final’ means the stage of a product
after which there is no known chance of value addition in it.
Released by National Statistical Office (NSO), Ministry of Statistics and Program
Implementation
Base Year The base year of the national accounts is chosen to enable inter-year
comparisons. It gives an idea about changes in purchasing power and allows
calculation of inflation-adjusted growth estimates. The last series has changed
the base year to 2011-12 from 2004-05.
Final Goods An item that is meant for final consumption and will not pass through any
more stages of production or transformations is called a final good. For
example, bread, butter, biscuits etc. used by the consumer
Intermediate Which are used as raw material or inputs for production of other commodities.
Goods These are not final goods. Eg- Rubber in Tyre
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Intermediate goods are not included in the calculation of national income.

Only final goods are included in the calculation of national income because
value of intermediate goods is already included in the value of final goods.
If it is included in national income it will lead to the problem of double
counting.
Indirect Indirect taxes are those taxes which are levied by the government on sales and
taxes production and also on imports of the commodities. For example, GST,
Import/custom duties etc.
Subsidies Government gives financial help to the production units for selling their
product at lower prices fixed by the government. Such help is given to those
commodities whose production government wants to encourage
Nominal GDP at current prices is called nominal GDP. But It does not show the true
GDP picture of economic growth of a country as any increase in nominal GDP might
be due to rise in price level without any change in physical output.
Real GDP In order to eliminate the effect of price changes, GDP is estimated at a
constant/base price called real GDP. Nominal GDP adjusted for inflation.
For developing countries inflation is high & unstable, hence they calculate
national income at constant prices to understand real picture.
Developed countries inflation has been around 2% for many decades. This is
why the difference between the incomes at constant and current prices among
them are narrow and they calculate their national income at current prices.
GDP Deflator GDP adjusted due to inflation on a base year = Nominal GDP / Real GDP
Methods for 1) Expenditure Method
calculating
GDP
2) 2) Income Method → Based on factor cost

Factor cost = Labor (Wages) + Capital (Interest) + Entrepreneurship (Profit) +
Land (Rent)
3) 3) Output Method: Production Method: Gross Value Added (GVA)

GDP (at current market price) = ∑ GVA of all goods and services produced +
Tax-Subsidies
GDP @ GDP @ Factor cost + Taxes – Subsidies
Market Price
Net NDP = GDP – Depreciation
Domestic  During production process fixed capital assets like machines, building etc.
Product get depreciated and their value goes down. This is known as normal wear
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(NDP) and tear of machinery or consumption of fixed capital or depreciation.

 The governments of the economies decide and announce the rates by
which assets depreciate (done in India by the Ministry of Commerce and
Industry) and a list is published, which is used by different sections of the
economy to determine the real levels of depreciations in different assets.
 NDP of an economy has to be always lower than its GDP for the same
year, since there is no way to cut the depreciation to zero.
Gross  GNP is the GDP of a country added with its ‘income from abroad’. In
National other words, it is the value of all finished goods and services owned by
Product a country's residents over a period of time
(GNP)  Here, the trans-boundary economic activities of an economy is also
taken into account.
 The items which are counted in the segment ‘Income from Abroad’ are:
Private Remittances, Interest on External Loans, External Grants.
 In India’s case ‘Income from abroad’ has always been negative (due to
heavy outflows on account of trade deficits and interest payments on
foreign loans)
 GNP = GDP+ NR (Net receipts from abroad or inflows from abroad) –
NP (Net payment outflow to foreign assets)
Net National NNP = GNP – Depreciation
Product
(NNP) When we divide NNP by the total population of a nation we get the ‘per capita
income’ (PCI) of that nation, i.e., ‘income per head per year’.
NNP at National Income= NNP at market prices – Indirect taxes + Subsidies
factor cost
or National But from January 2015 onwards, National Income in India is being computed at
Income market price i.e. National Income= NNP at market prices
Personal PI is the Part of National Income (NI) which is received by households.
Income
(PI) Personal Income (PI) = National Income – Undistributed profits – Net interest
payments made by households – Corporate tax + Transfer payments to the
households from the government and firms
New 1. Change of base year – 2004-05 to2011-12
Method 2. Change in GDP calculation to using market prices rather than factor costs.
from 2015 3. Adopted the international practice of valuing industry-wise estimates as
gross value added (GVA) at basic prices instead of factor cost.
GVA at basic prices = GVA at factor cost + production taxes less production subsidies.
GVA at factor cost = CE + OS/MI + CFC
[CE: compensation of employees; OS: operating surplus; MI: mixed income; and CFC:
consumption of fixed capital i.e., depreciation]
Production taxes or production subsidies are paid or received with relation to
production and are independent of the volume of actual production.
 Some examples of production taxes are land revenues, stamps and
registration fees and tax on profession.
 Some production subsidies are subsidies to Railways, input subsidies to
farmers, subsidies to village and small industries, administrative subsidies to
corporations or cooperatives, etc
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Gross value It is an economic productivity metric that measures the contribution of a

added (GVA) corporate subsidiary, company or municipality to an economy, producer,
sector or region.
GDP = GVA at basic prices + taxes on products – subsidies on products
Product taxes or subsidies are paid or received on per unit of the product.
 Some examples of product taxes are excise tax, sales tax, service tax
and import and export duties.
 Product subsidies include food, petroleum and fertilizer subsidies,
interest subsidies given to farmers, households, etc.
Gross Capital The percentage of the investment made each year out of the total GDP is
Formation called Gross Capital Formation.
(GCF) High GCF denotes higher rate of savings in the economy which is required for
high rate of production, capital formation, changes in production techniques.
GCF includes capital formation in public sector, private sector and also
household sector.
Purchasing Power Parity(PPP)

 It is the rate at which the currency of one country would have to be converted into
that of another country to buy the same amount of goods and services in each
country.
 The PPP exchange rates are constructed to ensure that the same quantity of goods
and services are priced equivalently across countries.
 The purchasing power parity formula can be expressed as
S = P1 / P2
Where,
S = Exchange rate of one currency 1 to currency 2
P1 = Cost of a good in currency 1
P2 = Cost of the same good in currency 2
 PPP exchange rates are used to convert the national poverty lines from some of the
poorest countries in the world to determine the Global Poverty Line.
 Government agencies use PPP to compare the output (GDP) of various countries.
 Note that Currency Exchange Rate in market is different from this theoretical
concept of PPP. (PPPs of Indian Rupee per US$ at GDP level is now 20.65 in 2017
from 15.55 in 2011)
Limitations of GDP
 Distribution of Wealth: The GDP system only counts the spending of wealth. It does
not account which wealth it belongs to. The top 10% richest can easily hold 50% of
the total value of an entire economy.
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 Environmental Damage: The GDP system would want companies and citizens to
spend and produce as much as possible, no matter how much it degrades the
environment.
 Well-Being: The GDP system only favors monetary value. Monetary value doesn’t
always mean happiness or good human well-being. For those who have worked to
escape poverty, happiness is a feeling, not a static objective. While having money
certainly helps, it doesn’t guarantee your happiness nor your well-being.
Alternatives to GDP
Human This gives a weighting to national income, life expectancy and quality
Development Index of education.
(HDI)
The index is composed of

1. Life Expectancy Index. Average life expectancy compared to a
global expected life expectancy.
2. Education Index
1. mean years of schooling
2. expected years of schooling
3. Income Index (Gross National Income – GNI at PPP)
Therefore, it is much more than GDP because it looks at education
standards, health care and life expectancy.
Human poverty It was introduced by UN Development Programme (UNDP)

index (HPI) To measure rates of economic development for low-income
countries it examines education, life expectancy, rates of absolute
poverty and access to health care and safe drinking water.
(HPI-1) It involves combining:
1. Probability at birth of not surviving to age 40 (times 100)
2. Adult illiteracy rate
3. Arithmetic average of these three characteristics:
o The percentage of the population without access to
safe water.
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o The percentage of population without access to health

services.
o The percentage of malnourished children under five.
Gross National GNH looks at nine different factors including psychological well-
Happiness (GNH) being, health, time use, education, cultural diversity and resilience,
good governance, community vitality, ecological diversity and
resilience, and living standards. The four pillars of GNH are:
 Sustainable and equitable socio-economic development;
 Environmental conservation;
 Preservation and promotion of culture
 Good governance.
It has been adopted by Bhutan since 2008 and is strongly influenced
by Buddhist concepts.
Happy Planet Index  This is a measure of human well being adjusted for
(HPI) environmental impact. It looks at life expectancy and life
satisfaction divided by the ecological impact of the nation.
 So if a country has a high carbon footprint, it will, ceteris
paribus have a lower HPI score because more resources are
needed.
 A high score would have a high life satisfaction combined with
low ecological footprint.
 The highest-ranking countries are in Central America –
Colombia, Costa Rica, Dominica and Panama.
 The US with high carbon footprint is ranked as one of the
lowest.
Green GDP  This adjusts GDP for resource depletion and environmental
degradation.
 In 2004, China experimented with green GDP. But, once
pollution and environmental costs were added in it displayed
zero growth. It was discarded in 2007.
 Pros: Green GDP embraces broader accounting of economic
development that considers the effects of pollution and
resource depletion.
 Cons: Local governments that don’t want their economic
growth statistics affected by environmental factors have been
resistant to adopting this as a GDP alternative.
Genuine Progress GPI starts with GDP as its base but also takes into account
Indicator (GPI) environmental and social factors such as
 Pollution
 Poverty rates
 Health standards
 Inequality rates
 Crime rates
 Cost of pollution abatement
 Cost of commuting
 Cost of road accidents
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 Value of education
 Value of housework and parenting
 This graph for global GPI, shows it is much harder to increase

GPI than GDP. This is because if people spend time sitting in a
traffic jam, that increases GDP but not GPI.
 Pros: GPI shifts the value basis of a product by adding its
social and environmental impacts to the equation. It also
assigns values to non-financial human contributions, such as
volunteering.
 Cons: Some finance professionals believe that non-economic
variables are too subjective and that GPI is not an effective
tool for assessing the state of the business cycle.
INFLATION
Before understanding the concept of inflation, it is important to the concepts of aggregate

demand and aggregate supply of the economy.
Aggregate Supply Aggregate Demand

Aggregate supply, also known as total It is the total demand of all products (goods
output, is the total supply of goods and and services) in an economy. It is expressed
services produced within an economy at a as the total amount of money exchanged for
given overall price in a given period. those goods and services at a specific price
level and point in time.
Aggregate supply= consumption + savings. It consists of four components
1. Consumption (C)
Various factors influence aggregate supply 2. Investment (I)
like existing levels of labor costs, physical 3. Government Spending (G)
capital, technology, and institutions. 4. Net Exports (Export-Import) (X-M)
Thus, Aggregate Demand = C + I + G + (X-M)
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Aggregate demand over the long-term

equals gross domestic product (GDP)
because the two metrics are calculated in
the same way.
The upward-sloping aggregate supply curve The downward-sloping aggregate supply

shows the positive relationship between curve shows the negative relationship
price level (final price of goods & services) between price level (final price of goods &
and aggregate supply. services) and aggregate demand.
The aggregate supply curve slopes up Downward slope indicates that increases in
because when the price level for outputs the price level of outputs lead to a lower
increases while the price level of inputs quantity of total spending (lower demand)
remains fixed, the opportunity for additional
profits encourages more production.
Shifts in Aggregate Supply curve is caused by Any change in the four components (C, I, G,
various reasons like changes in productivity, X) will cause a change in the aggregate
changes in labour costs, government policies, demand curve.
inflow of capital etc
For Example: Increase in government
For example: Ineffective transportation expenditure (increased salaries, increased
network & increase in labour costs leads to wage rates in MGNREGA) will increase
AS curve shifting leftwards i.e. due to aggregate demand and push AD curve
increased input costs (and output price outwards.
remaining same), the producer will produce
less goods to maintain his profits (Y1 to Y2 at Likewise, a fall in consumption & fall in
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GPL1) investment will lead to decrease in

Aggregate demand.
Likewise increased productivity/ innovation
which reduces input costs will help increase
production and shift the AS curve rightwards.
As per the British Economist, John Maynard Keynes,

when economy is functioning at full employment,
aggregate supply will match aggregate demand.
At this Equilibrium we will have general price level.
When the aggregate supply and aggregate

demand shift, so does the point of equilibrium
Keynes argued that in the event of depression, where

there is lower aggregate demand, government has to
step up and increase its expenditure so as to spur the
aggregate demand to revive the economy.
Inflation
 Inflation refers to a sustained/continuous rise in the general price level of goods and
services in an economy over a period of time.
 Inflation measures the average price change in a basket of commodities and services
over time.
 Inflation is indicative of the decrease in the purchasing power of a unit of a country’s

currency. This could ultimately lead to a deceleration in economic growth.
 High rates of inflation is bad because, it can eat up hard-earned money of ordinary
people. Life of common man will become tough.
 However, a moderate level of inflation is required in the economy to ensure that
production is promoted.
Types of Inflation
1. Demand-Pull Inflation
This type of inflation is caused due to an increase in aggregate demand in the economy.
 Price rise because aggregate demand in an economy is greater than the aggregate
supply (at full employment level) of goods and services.
 Thus there is a situation where too much money chasing few goods and services.
Some of the factors which leads increase in AD are

 A growing economy or increase in the supply of money – When consumers feel
confident, they spend more and take on more debt. This leads to a steady increase in
demand, which means higher prices.
 Asset inflation or Increase in Forex reserves- A sudden rise in exports forces a
depreciation of the currencies involved.
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 Government spending or Deficit financing by the government – When the

government spends more freely, spending capacity of people increased and as a
result prices go up.
 Due to fiscal stimulus
 Increased borrowing
 Depreciation of rupee
2. Cost-Push Inflation
 When price rise because aggregate supply in an economy declines or is lower than
the aggregate demand (at full employment level) of goods and services.
 This decline in aggregate supply is majorly due to rise in production cost.
 Cost pull inflation is considered bad among the two types of inflation. Because the
National Income is reduced along with the reduction in supply in Cost-push type of
inflation.
 This type of inflation is caused due to various reasons such as:
o Increase in wages of the employees
o Increase in price of inputs
o Hoarding and Speculation of commodities
o Defective Supply chain: Increases the transit cost of firms
o Increase in indirect taxes: It will be passed on to the consumers
o Crude oil price fluctuation: A rise in prices of oil will lead to rise in input cost
(transportation cost will increase) and thus will lead to cost push inflation.
o Depreciation of Currency (for India): Leads to increased import cost of Oil
which will further lead to inflation
o Food Inflation (growth agriculture sector has been averaging at low 3.5%)
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o Increase in Profit margin by firms: If firms decide to increase their profit

margin, it results in increase in prices of goods and services. It usually happen
when a single company id major supplier of the goods (monopoly)
o Interest rates were increased by RBI
3. Structural Inflation
It means that inflation is due to structural factors. For example
 Infrastructural bottlenecks, regulatory compliance burden will increase logistic cost
and will result in overall increase in prices of commodities
 Similarly, structural bottlenecks in agricultural sector such as APMCs, involvement of
middlemen, imperfect price discovery leads to rise in food prices
 Resource constraints (such as government Budget constrain) to finance
infrastructure development.
 Structural Inflation is generally significant in explaining the food inflation in India
Effects of Inflation
 The effect of inflation is not distributed evenly in the economy. There are chances of
hidden costs for different goods and services in the economy.
 Sudden or unpredictable inflation rates are harmful to an overall economy. They
lead to market instability and thereby make it difficult for companies to plan a
budget for the long-term.
 Inflation can act as a drag on productivity as companies are forced to mobilize
resources away from products and services to handle the situations of profit and
losses from inflation.
 Inflation leads to decline in the value of money over a period of time. It erodes
purchasing power of money. Thus it will hurt people with fixed income.
 People on fixed salaries, fixed pensions etc will be negatively impacted by the
inflation as they will be able to buy lesser.
 However, businessman and entrepreneurs may benefit from inflation as the price of
final product rises (faster than the input prices)
 Moderate inflation enables labour markets to reach equilibrium at a faster pace.
Effect of Inflation on lenders and borrowers

 Inflation is bad for lender and good for borrower. Inflation helps borrowers and hurt
lenders. Inflation re-distribute wealth from creditors to lenders.
 Lenders suffers due to inflation. It is because the money they get paid back has less
purchasing power than the money they loaned out.
 Borrowers benefit out of inflation. Inflation reduces the value of money. Interest
rate that a borrower pays is effectively lower thanks to inflation.
Steps to Check Inflation
1. Monetary Policy (Contractionary policy)

 The monetary policy of the Reserve Bank of India is aimed at managing the quantity
of money supply in an economy in order to meet the requirements of different
sectors of the economy and to boost economic growth.
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 When the total money supply is increased rapidly than normal, it is called an
expansionary policy while a decrease of the same refers to a contractionary policy.
 RBI adopts contractionary monetary policy when there is inflation especially if it is
demand pull inflation caused by increased money supply in economy. Here, RBI tries
to restrict the money supply in economy.
 This contractionary policy is manifested by decreasing bond prices and increasing
interest rates. This helps in reducing expenses during inflation which ultimately
helps halt economic growth and, in turn, the rate of inflation.
2. Fiscal Policy
 Fiscal policy deals with the Revenue and Expenditure policy of the government. It
deals with taxation, spending by government and borrowing.
 Tools of fiscal policy
o Direct taxes should be increased so as to decrease the purchasing power of
people that helps in controlling demand pull inflation
o Indirect taxes should be reduced
o Public Expenditure should be decreased (should borrow less from RBI and
more from other financial institutions)
3. Supply Management measures

 Import commodities which are in short supply
 Decrease exports
 Government may put a check on hoarding and speculation
 Distribution through PDS
Indices which measure inflation in an economy
Wholesale Price Index (WPI)

 WPI measures the changes in the prices of goods sold and traded in bulk by
wholesale businesses to other businesses. In other words, WPI tracks prices at the
factory gate before the retail level.
 The numbers are released by the Ministry of Commerce and Industry
 Base year is 2011-12. The new base year aligns with the base year of other indicators
like the GDP and IIP.
 Major criticism for this index is that the general public does not buy products at
wholesale price.
 Even as the WPI is used as a key measure of inflation in some economies, the RBI no
longer uses it for policy purposes, including setting repo rates.
 Provisional figures of WPU are released on 14th of every month (or next working
day) with a time lag of two weeks of the reference month and compiled with data
received from institutional sources and selected manufacturing units across India.
 WPI was revised in 2017 and key highlights are
o WPI continues to constitute three major groups—Primary Articles, Fuel and
Power, and Manufactured Products. The number of items has been
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increased from 676 to 697—in all 199 new items have been added and 146
old items have been dropped.
o The 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 (PPI).
o �Item level aggregates for new WPI have been compiled using Geometric
Mean (GM) following international best practice and as is currently used for
compilation of the CPI.
o A new Wholesale Food Price Index (WPFI) has been introduced—combining
the Food Articles (belonging to the group Primary Articles) and Food Products
(belonging to the group Manufactured Products).
Consumer Price Index (CPI) – Retail Inflation

 It is an index measuring retail inflation in the economy by collecting the change in
prices of most common goods and services used by consumers.
 It is released by Central Statistics Office (CSO) under Ministry of Statistics and
Programme implementation
 In April 2014, the RBI had adopted the CPI as its key measure of inflation
 At the national level, there are four Consumer Price Index (CPI) numbers. These are:
CPI Type Basket Base Utility

Year
CPI for Industrial 260 items (plus 2001  The wages/salaries of the central
Workers (IW) the services) government employees are revised
on the basis of the changes occurring
in this index, the dearness allowance
(DA) is announced twice a year.
 When the Pay Commission
recommends pay revisions, the base
is the CPI (IW).
CPI for 260 commodities 1986–87  This index is used for revising
Agricultural collected in 600 minimum wages for agricultural
Labourers (AL) villages with a labourers in different states.
monthly  Centre and states remain vigilant
frequency and regarding the changes in this index
has three weeks as it shows the price impact on the
time lag. most vulnerable segment of the
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society, this segment spends almost

75 per cent of its total income on the
purchase of food articles.
CPI for Rural 260 commodities 1983  The agricultural and rural labourers
Labourers (RL) collected in 600 in India create an overlap, i.e., the
villages with a same labourers work as the rural
monthly labourers once the farm sector has
frequency and either low or no employment scope.
has three weeks  Probably, due to this reason this
time lag. index was dropped by the
government in 2001–02.
 But after the government change at
the Centre the index was revived
again.
CPI for Urban 146–365 1984–85  This price index has limited use and
Non-Manual commodities in it is basically used for determining
Employees the basket for dearness allowances (DAs) of
(UNME). which data is employees of some foreign
collected at 59 companies operating in India (i.e.,
centres in the airlines, communications, banking,
country insurance, embassies and other
financial services).
 It is also used under the Income Tax
Act to determine capital gains.
 Since the publication of the CPI (U)
started the index was discontinued
with from January 2011.
 While the first three are compiled and released by the Labour Bureau in the Ministry
of Labour, the fourth one (CPI-UNME) is released by the Central Statistical
Organisation(CSO) in the Ministry of Statistics and Programme Implementation
 In 2011, CSO introduced three new CPI’s
o CPI – Urban
o CPI – Rural
o CPI – Combined
 The National Statistical Office (NSO), Ministry of Statistics and Programme
Implementation is releasing Consumer Price Index (CPI) on Base year 2012.
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Difference between WPI & CPI

 WPI, tracks inflation at the producer level and CPI captures changes in prices levels
at the consumer level.
 Both baskets measure inflationary trends (the movement of price signals) within the
broader economy, the two indices differ in which weightages are assigned to food,
fuel and manufactured items.
 WPI does not capture changes in the prices of services, which CPI does.
Headline Retail Inflation Vs Core Inflation

 Headline inflation is the raw inflation figure reported through the Consumer Price
Index (CPI) that is released by CSO. The headline figure is not adjusted for seasonality
or for the often-volatile elements
 Core inflation removes the CPI components that can exhibit large amounts of
volatility from month to month, which can cause unwanted distortion to the
headline figure. The most commonly removed factors are those relating to the cost
of food and energy.
Related Terms
Deflation  Deflation is a decrease in the general price levels of goods and
services. It is opposite of Inflation. During deflation prices of
goods and services tend to fall.
 Deflation occurs when inflation rate falls below 0%.
 It increases the value of Money
 It increases the Purchasing power of money. People can buy more
from same amount of money
 Deflation is good for lenders and bad for borrowers
 Deflation increases the real value of debt
 Thus deflation discourages borrowing (and by extension,
consumption and investment today.)
 People may have less propensity to spend and more to save as
they will hold on to in expectation of further decline in prices.
 In deflation, there is a steep decline in the general price level,
which indicates an unhealthy condition of the economy. It can
cause high unemployment, increase layoff, fall in the wage rates,
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decrease profits, low demand, low income, restricted credit

supply in the economy.
 Ways to Combat Deflation: Increase the credit supply in the
economy. Reduce repo rate, CRR and SLR
Galloping  This is a ‘very high inflation’ running in the range of double-digit
Inflation or triple digit (i.e., 20, 100 or 200 per cent in a year).
 In the decades of 1970s and 1980s, many Latin American
countries such as Argentina, Chile and Brazil had such rates of
inflation—in the range of 50 to 700 per cent.
 It is also known as jumping inflation and running or runaway
inflation
Hyperinflation  This form of inflation is ‘large and accelerating’ which might have
the annual rates in million or even trillion.
 In such inflation not only the range of increase is very large, but
the increase takes place in a very short span of time, prices shoot
up overnight.
 The best example of hyperinflation that economists cite is of
Germany after the First World War—in early 1920s.
 At the end of 1923, prices were 36 billion times higher than two
years earlier.
 This inflation was so severe that paper German currencies (the
Deutsche Mark) were more valuable as stove fuel than as actual
money
 Some recent examples of hyperinflation had been the Bolivian
inflation of mid-1985 (24,000 per cent per annum) and the
Yugoslavian inflation of 1993 (20 per cent per day)
Inflationary Gap  The excess of total government spending above the national
income (i.e., fiscal deficit) is known as inflationary gap.
 This is intended to increase the production level, which ultimately
pushes the prices up due to extra-creation of money during the
process.
Deflationary Gap  The shortfall in total spending of the government (i.e., fiscal
surplus) over the national income creates deflationary gaps in the
economy.
 This is a situation of producing more than the demand and the
economy usually heads for a general slowdown in the level of
demand. This is also known as the output gap
Inflation Tax  Inflation erodes the value of money and the people who hold
currency suffer in this process.
 As the governments have authority of printing currency and
circulating it into the economy (as they do in the case of deficit
financing), this act functions as an income to the governments.
 This is a situation of sustaining government expenditure at the
cost of people’s income.
 This looks as if inflation is working as a tax. That is how the term
inflation tax is also known as seigniorage.
 It could also be used by the governments in the form of prices and
ZGVmMjcxYTA3NGI1
incomes policy under which the companies pay inflation tax on

the salary increases above the set level prescribed by the
government
Stagflation  It is a situation where the inflation rate is high, the economic
growth rate slows down, and unemployment is also high
 Stagflation = High Inflation + High Unemployment + Stagnant
Growth
 It raises a dilemma for economic policy since actions designed to
lower inflation may exacerbate unemployment, and vice versa.
 It is unusual because policies to reduce inflation make life difficult
for the unemployed, while steps to alleviate unemployment raise
inflation.
Case of Stagflation
 In the early and mid-1970s when OPEC (The Organisation of
Petroleum Exporting Countries), which works like a cartel, decided
to cut supply and sent oil prices soaring across the world.
 On the one hand, the rise in oil prices constrained the productive
capacity of most western economies that heavily depended on oil,
thus hampering economic growth. On the other hand, the oil
price spike also led to inflation and commodities became more
costly.
 For instance, in 1974, the oil prices went up by almost 70% and it
leads to a consequent rise in inflation.
Skewflation  This occurs there is a price rise of one or a small group of
commodities over a sustained period of time
 In India, food prices rose steadily during the last months of 2009
and the early months of 2010, even though the prices of non-food
items continued to be relatively stable.
Disinflation  Reduction in the rate of inflation
Inflation Premium  The bonus brought by inflation to the borrowers is known as the
inflation premium.
 The interest banks charge on their lending is known as the
nominal interest rate, which might not be the real cost of
borrowing paid by the borrower to the banks.
 To calculate the real cost a borrower is paying on its loan, the
nominal rate of interest is adjusted with the effect of inflation and
thus the interest rate we get is known as the real interest rate.
 Rising inflation premium shows depleting profits of the lending
institutions. At times, to neutralise the effects of inflation
premium, the lender takes the recourse to increase the nominal
rate of interest
Misery index  Rate of inflation + Rate of unemployment
Philips Curve  It is a curve which provides relationship between inflation and
unemployment.
 As per the Philips curve, there is inverse relationship between
Inflation and Unemployment
ZGVmMjcxYTA3NGI1
 The underlying logic behind the Phillips curve is that wages are
quite “sticky”, or inflexible, in a market economy, so
unemployment is bound to shoot up whenever workers refuse to
accept lower wages
GDP Deflator  It is a measure of general price inflation.

 It is calculated by dividing nominal GDP by real GDP and then
multiplying by 100.
 GDP Deflator = (GDP at Current Prices/GDP at constant Price) *
100
 GDP deflator is much more broader and comprehensive measure
of inflation than CPI and WPI.
 GDP deflator reflects the prices of all domestically produced
goods and services in the economy whereas, other measures like
CPI and WPI are based on a limited basket of goods and services.
 GDP deflator also includes the prices of investment goods,
government services & exports, and excludes the price of imports.
 GDP deflator is usually released quarterly or yearly (CPI, WPI are
released monthly) by Ministry of Statistics and Program
Implementation.
Base Effect  It refers to the impact of the rise in price level (i.e., last year’s
inflation) in the previous year over the corresponding rise in price
levels in the current year (i.e., current inflation)
 When a change in the index in the base period has a considerable
effect on the measured inflation, this is called base effect of
inflation
 The index has increased by 20 points in all the three years, viz.,
2008, 2009 and 2010.
 However, the inflation rate (calculated on ‘year-on-year’ basis)
tends to decline over the three years from 20 per cent in 2008 to
14.29 per cent in 2010 (Base Effect)
 This is because the absolute increase of 20 points in the price
index in each year increases the base year price index by an
equivalent amount, while the absolute increase in price index
remains the same.
ZGVmMjcxYTA3NGI1
Inflation  In India, the RBI had earlier pursued a ‘multiple indicators

Targeting approach’, implying concern for outcomes other than inflation,
including even the balance of payments.
 However, the Indian government instituted inflation targeting as
the sole objective of monetary policy since 2016-17.
 While the Government of India tries to accelerate the GDP growth
rate of India, the RBI keeps trying to bring down the rate of
inflation within a sustainable limit known as inflation targeting.
 As a result, the Government of India and Reserve Bank of India
signed a Monetary Policy Framework Agreement in 2015.
 As per the agreement, RBI would set the policy interest rates and
would aim to bring inflation below 6 per cent by January 2016 and
within 4 per cent with a band of (+/-) 2 per cent for 2016-17 and
all subsequent years.
Monetary Policy  Setup based on recommendations of Urjit Patel committee.
Committee (MPC)  MPC consist of six members, 3 from RBI and 3 appointed by the
Government
 Members from RBI are governor of RBI (ex-officio Chairman), a
deputy governor and one officer of RBI.
 Members from government are appointed on the
recommendations of a search cum selection committee headed
by cabinet secretary and including RBI Governor, Economics
Affairs Secretary, three experts in the field of Banking/Finance.
Copyright © by IASbaba
All rights are reserved. No part of this document may be reproduced, stored in a retrieval
system or transmitted in any form or by any means, electronic, mechanical, photocopying,
recording or otherwise, without prior permission of IASbaba.

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PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

Open- economy Closed- economy

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

Intermediate goods are not included in the calculation of national income.

2) 2) Income Method → Based on factor cost

3) 3) Output Method: Production Method: Gross Value Added (GVA)

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

(NDP) and tear of machinery or consumption of fixed capital or depreciation.

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

Gross value It is an economic productivity metric that measures the contribution of a

GDP = GVA at basic prices + taxes on products – subsidies on products

Purchasing Power Parity(PPP)

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

The index is composed of

Human poverty It was introduced by UN Development Programme (UNDP)

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

o The percentage of population without access to health

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

 This graph for global GPI, shows it is much harder to increase

Before understanding the concept of inflation, it is important to the concepts of aggregate

Aggregate Supply Aggregate Demand

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

Aggregate demand over the long-term

The upward-sloping aggregate supply curve The downward-sloping aggregate supply

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

GPL1) investment will lead to decrease in

As per the British Economist, John Maynard Keynes,

When the aggregate supply and aggregate

Keynes argued that in the event of depression, where

 Inflation is indicative of the decrease in the purchasing power of a unit of a country’s

Some of the factors which leads increase in AD are

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

 Government spending or Deficit financing by the government – When the

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

o Increase in Profit margin by firms: If firms decide to increase their profit

Effect of Inflation on lenders and borrowers

Steps to Check Inflation

1. Monetary Policy (Contractionary policy)

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

3. Supply Management measures

Indices which measure inflation in an economy

Wholesale Price Index (WPI)

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

Consumer Price Index (CPI) – Retail Inflation

CPI Type Basket Base Utility

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

society, this segment spends almost

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

Difference between WPI & CPI

Headline Retail Inflation Vs Core Inflation

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

decrease profits, low demand, low income, restricted credit

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

incomes policy under which the companies pay inflation tax on

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY

GDP Deflator  It is a measure of general price inflation.

PRELIMS EXCLUSIVE PROGRAMME (PEP) 2022 -ECONOMY