Inflation is an economic term that means rising prices of goods and services within a particular economy over a particular time. And generally, with the rising prices of goods and services, the consumers’ purchasing power decreases also affecting certain other financial decisions. It is the rise in the general level of prices, in which a particular unit of currency buys less than it did as compared to the previous periods. This means that an individual would require about 1000 Rs. in 2020 to purchase the same amount of goods and services as 300 Rs. would have purchased in 1990.
Generally expressed in percentage, inflation indicates a decrease within the buying power of a nation’s currency. The measure of inflation over a while is referred to as the rate of inflation or the inflation rate.
Table of Contents
- General effects of Inflation
- How inflation is measured in India and US
- Causes of inflation
- Types of inflation based on the inflation rate
- What if the inflation becomes too high?
- Other negative impacts of Inflation
- Conclusion on the inflation rate
- What does the US do?
- How can to tackle inflation?
- Role of equities in tackling inflation
General effects of Inflation
Inflation affects consumer disbursement, enterprise investment, employment rates, government’s policies and programs, and interest rates. Once inflation is high, the value of living gets higher. Beyond reasonable level inflation ultimately hurts economic growth. Inflation can reduce the value of investment returns; hence clear understanding of inflation is extremely important.
If there is a lack of understanding of inflation then it can prove injurious to an investor’s investment portfolio. President Ronald Reagan said, “Inflation is as violent as a mugger, as scary as an armed robber, and as lethal as a hitman”. Although it can prove beneficial as when the economy is running below capacity, it means that there is somewhere unused labour or resources, so inflation supposedly helps increase production.
More rupees render to more spending, and hence more aggregated demand. More demand, to be met, triggers more production. So, a certain level of inflation is required in the economy to promote the production of goods and services and to discourage stocking of money in the savings. Till it is balanced and at an optimum level, it is really helpful for the economy. But beyond a certain level, it prevents companies from investing, saving increases, unemployment grows, and overall economic growth is badly affected.
As money generally loses its value over the time it is important to invest the money, hence ensuring the overall economic growth of the country. Individuals additionally invest in stocks as it benefits them.
Inflation, if done the right way, can prove beneficial to the economy. It enables economic growth. It allows adjustment of real wages and prices. It is better than deflation, where the general price levels in the country fall, as deflation can lead to recession.
How inflation is measured in India and US
In India, inflation is measured by the Ministry of Statistics and Programme Implementation, a central government authority, which ensures the smooth running of the overall economy. The Reserve Bank of India uses tools such as the repo rate (Repo rate is the rate at which the central bank of a country, in the event of any shortfall of funds, lends money to commercial banks) to limit the inflation within a band.
The government also influences inflation through its fiscal policy, taxation, etc. In India, two main indices exist to measure inflation, namely, Consumer Price Index (CPI) and Wholesale Price Index (WPI). They measure retail and wholesale price changes respectively. The CPI calculates the variation in the price of commodities and services such as food, education, electronics, clothes, medical care, etc. While on the other hand, WPI captures the goods or services sold to smaller businesses by larger businesses for selling further.
While in the US, the rate of inflation is determined by calculating changes in the average price of a constant bunch of goods and services, often called a market basket. Inflation is usually determined by using a general price index, such as the Consumer Price Index (CPI).
In a price index, the price of a market basket is divided in any given year by the base year’s basket’s price of the same goods and services.
The rate of inflation is then determined by calculating the change in the percentage in the price index, says Consumer Price Index (CPI), across different periods. For example, the CPI was approximately 253 in September 2018, and nearly 256 in September 2019, hence making the rate of inflation about 1.6% over this period of one year.
So basically, the fundamental notion behind determining inflation is that at a particular time, the price of a constant basket of goods and services. But in real life, this is next to impossible for basically two reasons. First, is the qualitative factor, that the quality of nearly all kinds of goods and services changes over time. Due to this reason, the increase in the prices over time is due to the enhancements in quality and not inflation.
For example, a movie ticket may cost more today than it used to be in the 1960s, but a cinema today is also in colour and offers way better resolution and services. So, it would be wrong to say that all of the increase in the price of movie tickets is due to inflation; only the part of the money that cannot be explained by quality improvements would be accredited to inflation. Second, new products are brought into the marketplace over time and are only gradually merged into price indices to make their fixed baskets as they are essentially different from any of the historical goods. Statistical agencies try to regulate data to explain such factors, because, if these problems are not suitably accounted for, the calculated inflation would not be accurate and most likely exaggerated.
Causes of inflation
Inflation is chiefly caused due to demand-pull and cost-push inflation. Demand-pull inflation happens when the demand for goods and services in the economy surpasses its capacity to produce them. As demand tops supply within the economy, there is pressure upon placed on prices of such goods and services resulting in the rising inflation. Cost-push inflation happens when there is an increase in the cost of input goods and services.
The main causes of inflation in India are low supply or production and higher demand of various commodities leading to a demand-supply gap which further leads to a hike in prices, that is, inflation, to facilitate production. Excessive flow of money also leads to a hike in prices as money loses its purchasing power. Some other major structural factors could be:
- Supply bottlenecks leading to a shortage of commodities.
- Middlemen deliberately causing the price increase.
- Cheap loans being availed by the bank
- Printing of more currency by the Central Bank of the nation.
- Economic growth giving more purchasing power in the hands of the people.
- Black marketing, hoarding also push up inflation.
- Increase in wages and salary.
Types of inflation based on the inflation rate
Creeping Inflation, as the name suggests is when the prices gently rise. It is conjointly referred to as Mild Inflation or Low Inflation as it is the lowest or the mildest form of inflation. Prices rising by less than 3% each year is Creeping Inflation. This kind of inflation makes people anticipate that the prices of the goods and services will keep on going higher.
If creeping inflation continues to persist for an extended time then it known as Chronic Inflation, as the rate of inflation continues to increase without any downturn, leading to Hyperinflation. It could be either in Continuation or it could be Intermittent. It occurs generally when there is an increase in production costs.
The inflation rate higher than the Creeping Inflation is Walking Inflation. When prices rise between 3% and 10% each year, then it is known as Walking Inflation. Walking inflation generally signals for the occurrence of running inflation hence it should be considered as a sign of caution, according to some economists. If not checked timely then it may eventually lead to running or Galloping inflation.
Walking inflation and Creeping inflation joined together are called Moderate Inflation. When prices rise below 10% per year, it is known as Moderate Inflation. It is generally more stable inflation.
A very rapid growth in the rate of inflation is known to be as Running Inflation. Prices rising between 10% to 20% per year, it is said to be running inflation.
When prices rise between 20% to 1000% per annum, galloping inflation or jumping inflation is said to have occurred. From the second five-year plan period, India is facing galloping inflation.
Prices at an alarmingly high rate lead to Hyperinflation. The inflation is so rapid that it becomes difficult to even measure its magnitude. However, when the inflation is more than 1000% per year, it is called as Hyperinflation. The worst example of hyperinflation ever recorded is of Zimbabwe from the year 2004 to the years 2009 under Robert Gabriel Mugabe’s rule.
What if the inflation becomes too high?
If inflation becomes too high, then it may lead people to severely restrain their use of the money or the currency, leading to speeding up in the inflation rate. High and quickening inflation completely hinders the normal workings of the economy, harming its ability to supply both goods and services. Hyperinflation can even lead to the complete relinquishment of the use of the country’s currency (for example- North Korea) and thus leading to the implementation of an external currency (in this case, dollars).
Inflation interrupts with the overall pricing mechanisms in the economy, consequentially resulting in businesses and individuals earning lower than the ideal spending, investment, and saving decisions. Moreover, due to inflation, people often engage in activities such as diverting resources, to protect themselves from the negative impact of inflation. But such decisions reduce the overall economic growth and hence resulting in the lowering of the living standards.
Other negative impacts of Inflation
Inflation lowers down the efficacy of money as a medium of exchange. High inflation would mean that it becomes tough to put a certain value on goods and services because the price or the value of money keeps on falling and falling. As discussed, the extreme cases of inflation, that is the hyperinflation prices can rise to an extent that money becomes insignificant and people start relying upon a trading system or a barter economy. For example, Germany 1922, Hungary 1946.
The instability of the inflation rate keeps on increasing with the increasing inflation. This would mean that it will be tougher to place a value on money, and hence it becomes even tougher to determine a store of value. And, with high inflation, there will be increased menu costs. This is the cost of changing price lists to show the changing worth of money.
Moreover, higher inflation is bad for capital investment, which would mean due to inflation there would be a lower accumulation of productive capital and hence leading to slower economic growth for a long time in the future. Businesses are very less interested in setting up the industries and factories using the current currency if the goods made today have to be sold in the future in return for the money that is worthless due to inflation. And also, a lesser or smaller capital stock would mean lesser labour productivity and hence meaning slower wage growth.
Louis R Woodhill has even documented that higher inflation leads to lower levels of investment, higher unemployment, and lower GDP growth.
With high inflation, there is a relocation in the purchasing power from those on fixed nominal incomes. This relocation of the purchasing power of currency will also occur between the international trading partners. Higher inflation (where there are fixed exchange rates) will affect the balance of trade and will be responsible for the exports of the economy to become more expensive. There can also be adverse effects to trade from an extended uncertainty in currency exchange prices resulting from the inflation.
Moreover, Inflation can give rise to enormous protests and revolutions. For example, inflation (food inflation, in particular) is known to be one of the key reasons that gave rise to the 2011 Egyptian revolution and the 2010–11 Tunisian revolution, according to many witnesses also including Robert Bruce Zoellick, the then resident of the World Bank. Egyptian President Hosni Mubarak was exiled only after18 days of demonstrations and the protests and the Tunisian president Zine El Abidine Ben Ali was also exiled, and the demonstrations soon spread into several countries of North Africa and the Middle East.
The allocative efficiency is also affected, as the relative price of goods and services is likely to change when there is a change in their supply, giving out a signal to both the sellers and the buyers to redistribute the resources in reply to the new economic conditions. But when the prices keep on changing due to inflation, the changes caused because of genuine relative price signals, say quality, actually become difficult to differentiate from the change in prices caused because of the inflation, and hence the agents are slow to retort to them, which eventually lead to low resource allocative efficiency.
Also, with high inflation, companies must keep on changing their prices often from the “menus” to keep up with the changes caused due to inflation. But repeatedly changing prices is itself a rather expensive activity whether it is the requirement to print new menus, or it is the extra effort and time to put in to keep on changing the prices.
It can be concluded that inflation is the silent danger that eats away the real worth of your money over time.
Conclusion on the inflation rate
So, it can be deduced that any kind of unpredictable or high rate of inflation is regarded to be as detrimental to the overall economy. They increase inadequacies in the entire market and hence make it tough for individuals or companies to decide on a budget or to plan for the long-term. Inflation can prove to be a strain on the overall productivity as the companies in this situation are forced to move the resources away from the goods and services to concentrate on profit and losses caused due to the inflation. Savings and investment are discouraged due to the ambiguity about the forthcoming purchasing power of money. Inflation can also be the reason to enforce the hidden tax increases.
What does the US do?
Countries such as the US it is usually agreed upon that inflation should be kept as little as possible to curtail these distortions in the economy. Some economists would argue that a zero-inflation rate is ideal; but a zero rate of inflation can make an accidental deflation to occur, which would be even costlier than inflation itself. So, to balance out these two risks, often there is a positive approach, such as to keep inflation low, that is around 2%, to lower the inadequacies within the economy while at the same time shielding against deflation.
How can to tackle inflation?
The best way to beat inflation is to start saving investing and saving early in assets whose returns will ultimately beat the rate of inflation. One has to invest in growth assets, for example, real estate and equities. It can produce both income and capital appreciation.
But while choosing as to why buying assets you should always take the inflation rate in the consideration. Otherwise, it might expose you to the risk of gaining negative returns. It would guarantee the return you get is a few percentage points higher than the percentage of the inflation rate.
Role of equities in tackling inflation
Stocks carry the potential with them to give returns higher than the rate of inflation. Moreover, if the investment is held for more than a year, then the returns you get from equities are not even taxed! Those who want to make investments at once can construct their very own portfolio. For the rest, the alternative source for the equity funds could be mutual fund houses!
Thanks for reading….!!!!