Inflation and the Economy
Why prices rise over time, what causes inflation, who it hurts and helps, and how it is controlled.
The big idea
Think first
The same cup of tea costs three times what it did a decade ago. Where did the missing value of your money go, and who quietly gains from the change? Read on.
If a cup of tea that cost ₹5 a decade ago now costs ₹15, that is inflation at work. Inflation is a general rise in prices over time. It affects everyone by eroding the value of money in our pockets. Understanding what causes it, whom it hurts, and how it is controlled is central to macroeconomics and to everyday life.
What is inflation
Inflation is a sustained rise in the general level of prices in an economy over time. Its direct effect is to reduce the purchasing power of money: each rupee buys less than before.
Inflation is measured by price indices such as the Consumer Price Index (CPI) and Wholesale Price Index (WPI). These indices track the average prices of a basket of goods. A little inflation is normal in a growing economy. The danger arises when it becomes high or unpredictable. (The opposite, a fall in the general price level, is called deflation.)
CPI versus WPI
The two main indices differ in what they cover and how they weight it.
- Coverage: the WPI covers only goods traded at wholesale prices. It does not capture the prices of services. The CPI includes services such as health, education and transport, because consumers actually buy them.
- Food weight: food carries a higher weight in the CPI than in the WPI. Food inflation therefore moves the CPI more sharply than the WPI.
- Frequency: the WPI is released monthly.
- Policy anchor: the RBI now uses the CPI, not the WPI, as its headline inflation measure when setting policy interest rates.
The WPI itself has been revised over time. The series with base year 1993-94 became effective from April 2000, replacing the earlier 1981-82 base. In that revised series, the weight given to electricity increased. (As a related marker of the same period, India's foreign exchange reserves crossed USD 125 billion in 2004.)
India also publishes consumer indices for specific groups. The Consumer Price Index for Industrial Workers (CPI-IW) is compiled and published by the Labour Bureau, which works under the Ministry of Labour and Employment.
The base effect
Year-on-year inflation compares prices today with prices a year ago. The base effect is the impact of that previous year's price level on the calculated inflation rate. If prices were unusually low last year, the same prices today show a high inflation rate, even without any fresh price rise. A high base last year has the opposite effect and makes current inflation look low.
Previous-year questions
Previous-year question
2020UPSCConsider the following statements:
- The weightage of food in Consumer Price Index (CPI) is higher than that in Wholesale Price Index (WPI).
- The WPI does not capture changes in the prices of services, which CPI does.
- 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?
Previous-year question
2015UPSCWhich of the following brings out the 'Consumer Price Index Number for the Industrial Workers'?
Previous-year question
2011UPSCA rapid increase in the rate of inflation is sometimes attributed to the 'base effect'. What is 'base effect'?
Previous-year question
2010UPSCWhich one of the following statements is an appropriate description of deflation?
Previous-year question
2010UPSCWith reference to India, consider the following statements:
- The Wholesale Price Index (WPI) in India is available on a monthly basis only.
- As compared to Consumer Price Index for Industrial Workers (CPI-IW), the WPI gives less weight to food articles.
Which of the statements given above is/are correct?
Previous-year question
2005UPSCConsider the following statements:
- During the year 2004, India's foreign exchange reserves did not exceed the 125 billion U.S. dollar mark.
- The series of index numbers of wholesale prices introduced from April, 2000 has the year 1993-94 as base year.
Which of the statements is/are correct?
Previous-year question
2002UPSCWith reference to the Wholesale Price Index (WPI), consider the following statements:
- The new WPI series with base 1993-94 = 100 became effective from April 1998
- In the new WPI series, became effective from 1 April 2000.
- The weight for electricity has increased in the new WPI series
Which of these statements are correct?
Previous-year question
2001UPSCThe new series of Wholesale Price Index (WPI) released by the Government of India is with reference to the base prices of:
Previous-year question
1997UPSCIn India, inflation is measured by the:
Causes of inflation
Inflation generally arises in two ways:
- Demand-pull inflation: when total demand exceeds supply: too much money chasing too few goods. This can happen in a booming economy or when the money supply grows too fast.
- Cost-push inflation: when the costs of production rise (wages, raw materials, fuel), and firms pass these higher costs on to consumers as higher prices.
A rise in global oil prices, for example, can cause cost-push inflation across many goods at once.
Why food inflation persists in India
Food prices in India have often risen faster than other prices, and for structural reasons rather than passing shocks.
- Changing consumption patterns: rising incomes shift diets towards protein-rich foods such as milk, eggs, fruits and vegetables. Demand for these items grows faster than their supply.
- Supply-chain constraints: weak storage, poor transport links and long marketing chains limit how quickly food supply can respond, so shortages translate into higher prices.
One claim sometimes made is false: the area under food grain cultivation has not fallen by anything close to 30 per cent. Shrinking acreage is not the cause of India's persistent food inflation.
Previous-year questions
Previous-year question
2021UPSCWhich one of the following is likely to be the most inflationary in its effects?
Previous-year question
2021UPSCWith reference to Indian economy, demand-pull inflation can be caused/increased by which of the following?
- Expansionary policies
- Fiscal stimulus
- Inflation-indexing wages
- Higher purchasing power
- Rising interest rates
Select the correct answer using the code given below.
Previous-year question
2013UPSCA rise in general level of prices may be caused by:
- An increase in the money supply
- A decrease in the aggregate level of output
- An increase in the effective demand
Select the correct answer using the codes given below:
Previous-year question
2013UPSCWhich one of the following is likely to be the most inflationary in its effect?
Previous-year question
2011UPSCEconomic growth is usually coupled with?
Previous-year question
2011UPSCIndia has experienced persistent and high food inflation in the recent past. What could be the reasons?
- Due to a gradual switchover to the cultivation of commercial crops, the area under the cultivation of food grains has steadily decreased in the last five years by about 30%.
- As a consequence of increasing incomes, the consumption patterns of the people have undergone a significant change.
- The food supply chain has structural constraints.
Which of the statements given above are correct?
Effects and control of inflation
Inflation has uneven effects:
- it hurts savers, fixed-income earners and the poor, whose money loses value, and
- it can benefit borrowers (who repay in cheaper money) and some businesses, at least for a while.
High inflation creates uncertainty and can harm growth. Governments and central banks therefore work to control it through:
- monetary policy: the central bank raising interest rates or reducing the money supply to cool demand, and
- fiscal policy: the government adjusting taxes and spending.
Keeping inflation low and stable is a key goal of economic policy. This must be balanced against the need to support jobs and growth.
Previous-year questions
Previous-year question
2015UPSCWith reference to inflation in India, which of the following statements is correct?
Previous-year question
2013UPSCConsider the following statements:
- Inflation benefits the debtors.
- Inflation benefits the bond-holders.
Which of the statements given above is/are correct?
Direct and indirect taxes
Fiscal policy runs on taxes, so the tax system deserves a closer look. Taxes fall into two broad classes. A direct tax is paid by the same person on whom it is levied, and its burden cannot be shifted to anyone else. An indirect tax is levied on goods or services, and the seller passes its burden on to the final consumer.
- Direct taxes: income tax, corporation tax (tax on company profits), wealth tax, Fringe Benefit Tax (a tax on perks employers give employees), Interest Tax, and the Securities Transaction Tax (a tax on stock-market trades). All of these fall directly on the assessee.
- Indirect taxes: customs duty (on imports and exports), excise duty (on goods manufactured within the country), service tax, and sales tax or VAT. Their burden travels down the chain to the consumer.
Service tax, levied before GST replaced it, was an indirect tax of the Central Government, imposed under the Finance Act. Two fine points from income-tax law are frequently tested. Agricultural income is exempt from income tax, but income from allied activities such as poultry farming and wool rearing does not count as agricultural income and is taxable. Separately, rural agricultural land is not a capital asset under the Income-tax Act, 1961, so its sale does not attract capital gains tax.
Previous-year questions
Previous-year question
2025UPSCConsider the following statements: Statement I: In India, income from allied agricultural activities like poultry farming and wool rearing in rural areas is exempted from any tax. Statement II: In India, rural agricultural land is not considered a capital asset under the provisions of the Income-tax Act, 1961. Which one of the following is correct in respect of the above statements?
Previous-year question
2009UPSCConsider the following:
- Fringe Benefit Tax
- Interest Tax
- Securities Transaction Tax
Which of the above is/are Direct Tax/Taxes?
Previous-year question
2006UPSCWhich one of the following is the correct statement? Service tax is a/an:
Previous-year question
2001UPSCConsider the following taxes: I. Corporation tax II. Customs duty III. Wealth tax IV. Excise duty Which of these is/are indirect taxes?
Distribution of taxes between Centre and States
The Constitution divides taxing powers between the Union and the States. Who levies a tax, who collects it, and who keeps the money can be three different answers.
- Sales tax: a State subject in the pre-GST era. The tax on everyday purchases like toothpaste was both imposed and collected by the State Government.
- Securities Transaction Tax: taxes on transactions in stock exchanges and futures markets are levied and collected by the Union, not the States.
- Article 268: stamp duties on financial transactions such as bills of exchange and cheques are levied by the Union but collected and appropriated by the States.
- Article 270: income tax is levied and collected by the Union and then distributed between the Union and the States on the recommendations of the Finance Commission (the constitutional body that decides tax sharing).
- Article 271: surcharges on Union taxes belong exclusively to the Union and are not shared.
Corporation tax sits in the Union List (Entry 85). It is levied by the Union, and its proceeds traditionally belonged to the Union exclusively, outside the shared pool. The 80th Amendment (2000) later brought all Union taxes into a common divisible pool, but the classic position remains that corporation tax is a Union levy that the States cannot claim as their own.
Previous-year questions
Previous-year question
2014UPSCThe sales tax you pay while purchasing a toothpaste is a:
Previous-year question
2010UPSCConsider the following statements: In India, taxes on transactions in Stock Exchanges and Futures Markets are:
- levied by the Union.
- collected by the States.
Which of the statements given above is/are correct?
Previous-year question
2003UPSCConsider the following statements: In India, stamp duties on financial transactions are:
- Levied and collected by the State Government
- Appropriated by the Union Government.
Which of these statements is/are correct?
Previous-year question
1999UPSCWhich one of the following statements regarding the levying, collecting and distribution of Income Tax is correct?
Previous-year question
1995UPSCCorporation tax:
Tax reforms in India
India has reformed its tax system in waves. A constant motive is black money, income hidden from the authorities. Its chief harm to the government is the loss of revenue to the state exchequer through tax evasion, which starves public finances.
- Minimum Alternate Tax (MAT): introduced in the Union Budget of 1996-97. It makes companies with large book profits pay a minimum tax even when exemptions wipe out their normal liability.
- Uniform sales tax rates: the Standing Committee of State Finance Ministers recommended in January 2000 uniform floor rates of sales tax across States, to end tax competition between them.
- Kelkar proposals: the task forces under Dr Vijay L. Kelkar (2002) recommended sweeping tax reforms, direct and indirect. The direct-tax task force recommended abolition of the Wealth Tax, which raised little revenue relative to its cost.
- Equalization levy: a 6 per cent tax on online advertisement services supplied by non-resident entities, introduced in 2016. It was brought in through the Finance Act, not the Income Tax Act, and foreign firms cannot claim credit for it under Double Taxation Avoidance Agreements.
- Base Erosion and Profit Shifting (BEPS): an OECD initiative to curb tax avoidance by multinational companies that shift profits to low-tax jurisdictions and erode the tax base of countries where they earn.
Previous-year questions
Previous-year question
2021UPSCWhich one of the following effects of creation of black money in India has been the main cause of worry to the Government of India?
Previous-year question
2018UPSCWith reference to India's decision to levy an equalization tax of 6% on online advertisement services offered by non-resident entities, which of the following statements is/are correct?
- It is introduced as a part of Income Tax Act.
- Non-resident entities that offer advertisement services in India can claim a tax credit in their home country under the "Double Taxation Avoidance commission".
Select the correct answer using the code given below:
Previous-year question
2016UPSCThe term 'Base Erosion and Profit Shifting' is sometimes seen in the news in the context of:
Previous-year question
2004UPSCWhich of the following is a recommendation of the task force on direct taxes under the chairmanship of Dr Vijay L. Kelkar in the year 2002?
Previous-year question
2003UPSCThe Kelkar proposals which were in the news recently were the:
Previous-year question
2000UPSCThe Standing Committee of State Finance Ministers recommended in January 2000 uniform rates across the States in respect of:
Previous-year question
1997UPSCThe Minimum Alternative Tax (MAT) was introduced in the Budget of the Government of India for the year:
GST and value added tax
Value Added Tax (VAT) replaced the old cascading sales tax in the States. Its defining features: it is a multi-point, destination-based tax, it is levied on the value added at each stage of the production-distribution chain, and its burden is ultimately borne by the final consumer. One thing VAT was not: a central tax. VAT was a subject of the State Governments, not of the Centre.
The Goods and Services Tax (GST), launched in 2017, carried this logic nationwide. Its most realistic advantage is that it replaced multiple taxes collected by multiple authorities and created a single national market. Claims that GST would slash the Current Account Deficit or let India overtake China are exaggerations, not genuine benefits.
GST keeps basic items out of the net. Hulled cereal grains, chicken eggs and newspapers (even those carrying advertising material) are exempt. But processed and canned fish is a manufactured product and attracts GST.
Previous-year questions
Previous-year question
2018UPSCConsider the following items:
- Cereal grains hulled
- Chicken eggs cooked
- Fish processed and canned
- Newspaper containing advertising material
Which of the above items is/are exempted under GST (Goods and Services Tax)?
Previous-year question
2017UPSCWhat is/are the most likely advantages of implementing 'Goods and Services Tax (GST)'?
- It will replace multiple taxes collected by multiple authorities and will thus create a single market in India.
- It will drastically reduce the 'Current Account Deficit' of India and will enable it to increase its foreign exchange reserves.
- It will enormously increase the growth and size of economy of India and will enable it to overtake China in the near future.
Select the correct answer using the code given below:
Previous-year question
2011UPSCWhich one of the following is not a feature of 'value added tax'?
Trends in tax revenue
Aggregate tax numbers move with the economy, and they do not move in straight lines. India's tax-to-GDP ratio has fluctuated over the past decade rather than rising steadily. The fiscal deficit as a share of GDP has likewise risen and fallen with the cycle, with no steady upward march.
Within gross tax revenue, the composition has shifted. The share of excise duty in gross tax revenue declined significantly in the years before 2010, as rates were cut and many goods were exempted. Direct taxes such as personal income tax and corporation tax grew in relative importance over the same period.
Previous-year questions
Previous-year question
2017UPSCConsider the following statements:
- Tax revenue as a percent of GDP of India has steadily increased in the last decade.
- Fiscal deficit as a percent of GDP of India has steadily increased in the last decade.
Which of the statements given above is/are correct?
Previous-year question
2010UPSCIn India, the tax proceeds of which one of the following as a percentage of gross tax revenue has significantly declined in the last five years?
Key takeaways
- Inflation is a sustained rise in the general price level, reducing money's purchasing power. Measured by indices like CPI and WPI.
- WPI covers only goods; CPI includes services
- Food weighs more in CPI than WPI
- RBI sets policy rates using CPI, not WPI
- WPI base 1993-94 effective April 2000; electricity weight rose
- CPI-IW: Labour Bureau, Ministry of Labour and Employment
- Base effect: last year's low base inflates measured inflation
- Food inflation: richer diets plus weak supply chains
- Demand-pull inflation: demand exceeds supply (too much money chasing too few goods). Cost-push inflation: rising production costs.
- It hurts savers, fixed-income earners and the poor, while sometimes helping borrowers
- It is controlled through monetary policy (interest rates, money supply) and fiscal policy (taxes, spending)
- Direct taxes: income, corporation, wealth, FBT, Interest Tax, STT
- Indirect taxes: customs, excise, service tax; burden shifts to consumer
- Article 268: stamp duties Union-levied, State-collected; Article 270: income tax shared
- Corporation tax: Union List Entry 85, a Union levy
- MAT introduced in Budget 1996-97; Kelkar 2002 urged Wealth Tax abolition
- Equalization levy 6% via Finance Act; BEPS: OECD curbs MNC avoidance
- VAT: multi-point, destination-based, State subject, consumer bears burden
- GST exempts hulled cereals, eggs, newspapers; canned fish taxed
- Excise duty's share of gross tax revenue declined; tax-GDP ratio fluctuates
You’ve reached the end of this topic.
Review the takeaways above, then mark it done.