Inflation - Measurement and Control for UPSC

What Is Inflation?

Inflation measures the percentage change in the overall price level across the economy over time. It is not limited to any one commodity but reflects broad price movements. Economists classify inflation by intensity: mild (up to about 3 % a year), moderate (around 3–7 %), and high or galloping (above 10 %). In extreme cases inflation can become hyperinflation, where prices rise so quickly that money virtually loses value. Inflation can also be described by its origin — demand‑pull, cost‑push, structural and imported inflation — and by its scope, such as headline versus core inflation. Deflation, by contrast, is a persistent fall in prices, while disinflation refers to a decline in the rate of inflation.

Types and Sources of Inflation

The underlying causes of inflation determine its character and policy response:

• Demand‑pull inflation: When aggregate demand rises faster than the economy’s capacity to supply goods and services, prices are bid up. Higher incomes, generous fiscal spending, easy credit conditions or a boom in exports can all generate excess demand.
• Cost‑push inflation: Rising input costs force firms to raise prices. Higher wages, dearer energy, a weaker rupee that makes imports costlier, or higher indirect taxes can all feed into cost‑push inflation.
• Structural inflation: In developing countries supply bottlenecks such as inadequate storage, poor transport or seasonal factors restrict output. These structural problems prevent supply from responding quickly to demand, causing prices to rise.
• Imported inflation: When global commodity prices – especially crude oil and food – rise sharply, or when the domestic currency depreciates, the cost of imported goods increases and passes through to domestic prices.
• Built‑in inflation: Expectations matter. If workers and businesses expect prices to rise, they adjust wages and prices accordingly, triggering a wage–price spiral that becomes self‑reinforcing.

Inflation can be headline or core. Headline inflation captures all items in the price index, including volatile food and fuel. Core inflation strips out these items to reveal the underlying trend that monetary authorities seek to control.

Measuring Inflation in India

Inflation is measured by comparing the price of a representative basket of goods and services today with its price in a base year. The two main indices used in India are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). A third measure, the GDP deflator, derives from national accounts. Each index serves a distinct purpose:

Consumer Price Index (CPI)

CPI tracks retail prices paid by households for a fixed basket comprising food, clothing, housing, fuel, transportation, healthcare and other services. Separate indices are compiled for rural and urban areas and then combined into an all‑India measure. The base year is currently 2012, and a revision is expected soon to account for changing consumption patterns. CPI inflation is the target variable for the Reserve Bank of India’s monetary policy; under the inflation‑targeting framework the RBI aims for 4 % inflation with a tolerance band of ±2 %. In August 2025 headline CPI inflation ticked up to about 2.1 % year‑on‑year from 1.6 % in July, reflecting higher vegetable and protein prices, while food inflation remained slightly negative due to good harvests.

Wholesale Price Index (WPI)

The WPI measures price changes at the producer or wholesale level. It covers only goods, grouped into primary articles (agricultural produce and minerals), fuel and power, and manufactured products. Weights are based on production values rather than consumption. The current base year is 2011‑12. WPI inflation is useful for tracking supply‑side pressures; in September 2025 it was roughly 0.1 %, with negative inflation in primary articles and fuel offset by moderate increases in manufactured goods. WPI used to be India’s headline inflation indicator, but since 2014 the focus has shifted to CPI.

GDP Deflator

The GDP deflator measures the change in prices of all final goods and services produced within the country. It is calculated by dividing nominal GDP (valued at current prices) by real GDP (valued at constant prices) and multiplying by 100. Unlike CPI and WPI, the deflator has no fixed basket and automatically reflects changing composition of output. It currently uses 2011‑12 as the base year; the government plans to update the base to 2022‑23. The GDP deflator is broad and includes investment goods and services, making it useful for analysing economy‑wide inflation but less relevant for cost‑of‑living comparisons.

Core vs Headline Inflation

To understand short‑term price pressures, policymakers often focus on core inflation. The table below summarises the differences:

Causes and Effects of Inflation

Inflation rarely stems from a single factor. In India, excess demand fuelled by rising incomes and government spending often coincides with supply constraints such as poor logistics, labour shortages or unfavourable weather. Global factors like oil prices and exchange rate movements also matter. If inflation expectations become entrenched, wage demands and pricing behaviour can perpetuate inflation even when demand slows.

The effects of inflation depend on its pace and predictability. Moderate inflation can encourage consumption and investment by signalling rising demand. It allows relative prices to adjust and can help borrowers by reducing the real value of debt. High or volatile inflation, however, hurts savers and people on fixed incomes, widens inequality, distorts investment decisions and can undermine export competitiveness if domestic prices rise faster than those of trading partners. Maintaining low and stable inflation is therefore a key macroeconomic objective.

How India Controls Inflation

Monetary policy: The RBI uses tools such as the repo rate, reverse repo rate, cash reserve ratio and open market operations to influence the money supply and borrowing costs. When inflation rises above the target, the RBI may raise the repo rate or absorb liquidity through open market sales of government securities. The Monetary Policy Committee, set up under the amended RBI Act (2016), meets regularly to set the policy rate. In 2025 the repo rate remained at 6.5 % to balance price stability with growth.

Fiscal and supply‑side measures: The government can reduce demand by curbing non‑essential expenditure, improving targeting of subsidies and rationalising taxes. On the supply side, maintaining adequate buffer stocks of foodgrains, encouraging imports of scarce commodities and investing in storage, irrigation and transport infrastructure help relieve supply bottlenecks. Structural reforms in agriculture, industry and services improve productivity and expand supply, helping to contain inflation over the medium term. Coordination between the RBI and the government is essential because fiscal deficits financed by borrowing can push up money supply and undermine monetary policy efforts.

UPSC Notes: Prelims and Mains

For Prelims: Remember the definitions of inflation, deflation and stagflation; recognise the different types of inflation by intensity and source; note the base years and compiling agencies of CPI (2012, National Statistical Office), WPI (2011‑12, Office of the Economic Adviser) and GDP deflator (implicit, same as national accounts). Be clear that CPI includes services while WPI does not, and that RBI targets CPI inflation at 4 % ± 2 %. Latest data (mid‑2025) show headline CPI inflation around 2 % and WPI inflation near zero.

For Mains: Be prepared to discuss how inflation affects different groups in society; analyse recent inflation trends in India and identify demand‑pull and cost‑push factors; evaluate the role of the Monetary Policy Committee and the inflation‑targeting regime; and examine how fiscal policies and supply‑side reforms can complement monetary policy. You may also be asked to explain concepts like core inflation, imported inflation or the Phillips curve and their relevance for India.

Quick Facts

• Current base years: CPI (2012), WPI (2011‑12) and GDP deflator (2011‑12). A revision of CPI’s base year to 2024 and GDP/WPI to 2022‑23 is in progress.
• Inflation target: 4 % ± 2 % for CPI inflation, set under the Monetary Policy Framework Agreement between the RBI and Government of India.
• Latest data (2025): Headline CPI inflation around 2 %, core inflation ~3–4 %, WPI inflation ~0.1 %. Food inflation has been negative due to good harvests.
• Weight structure: In WPI the share of manufactured products is about 64 %, primary articles 23 % and fuel & power 13 %. CPI gives maximum weight to food and beverages.
• The GDP deflator has a changing basket because it covers all goods and services produced domestically, including investment goods and exports.

UPSC Previous Year Questions

1. Prelims 2017: With reference to the Consumer Price Index and the Wholesale Price Index, which one of the following statements is correct?
   • CPI covers services whereas WPI does not.
   • CPI uses production‑weighted baskets whereas WPI uses consumption‑weighted baskets.
   • Both indices are compiled by the National Statistical Office.
   • WPI is the sole target for monetary policy in India.
   Answer: Only option (a) is correct.
2. Mains 2019 (GS III): “Inflation targeting has helped anchor inflation expectations in India, but supply‑side shocks and fiscal policies limit its effectiveness.” Discuss with reference to recent inflation trends.

Practice MCQs

Try these objective questions to test your understanding. The answer key is given below.

1. Which of the following would most likely cause demand‑pull inflation?
   1. An increase in oil prices due to international supply cuts
   2. A sharp depreciation of the rupee
   3. Large government spending financed by borrowing
   4. Tighter monetary policy by the RBI
2. In India, the Monetary Policy Committee uses which price index as the nominal anchor for inflation targeting?
   1. GDP deflator
   2. Wholesale Price Index
   3. Consumer Price Index (combined)
   4. Producer Price Index
3. Which of the following statements best describes the GDP deflator?
   1. It measures only the prices of agricultural products.
   2. It tracks prices of a fixed basket of consumer goods.
   3. It reflects price changes of all goods and services produced domestically.
   4. It is compiled by the Ministry of Commerce and Industry.

Answer Key

1. (c)
2. (c)
3. (c)

Frequently Asked Questions

What is the difference between headline and core inflation?

Headline inflation measures the overall change in prices, including all items in the CPI basket. Core inflation excludes volatile food and fuel items to reveal the underlying trend. Policymakers watch core inflation to gauge whether price pressures are persistent.

Why does the RBI use CPI instead of WPI to set policy?

CPI reflects the cost of living faced by households because it includes services such as education, healthcare and housing. WPI tracks wholesale prices of goods and excludes services, so it does not capture consumer experience. That is why CPI is used as the target variable for monetary policy.

Can inflation be good for the economy?

A low and stable rate of inflation can encourage spending and investment, signal healthy demand and allow relative prices to adjust. However, high or unpredictable inflation hurts savers, erodes real incomes and distorts investment decisions.

What measures can control inflation?

Inflation can be controlled by tightening monetary policy (raising interest rates, absorbing excess liquidity), curbing unnecessary government spending, improving targeting of subsidies, building buffer stocks of essential commodities, and investing in infrastructure to relieve supply bottlenecks. Structural reforms that enhance productivity also help control inflation over the long run.